Hello, and welcome to the Download. I'm your host, Dave Richardson, and we have a real special edition of the podcast today. We've got Karim Hamasni back. He's the director of Crypto Asset Innovation at RBC, and Karim, I guess, you were on maybe about a month ago. And just tremendous feedback, by the way. I'll get you some of the comments, but everyone really loved the discussion. You do such a great job of breaking down an area of the world that, particularly for old guys like me, but I think for almost everybody, it's tough to understand and wrap your head even when you've worked in the investment business, which is the whole cryptocurrency blockchain space. Again, thanks for that visit and thanks for making yourself available today as there's a lot of news breaking in the cryptocurrency world.

Thank you, Dave, I'm happy to be here.

Great. So the collapse of this FTX network, in simple terms, what happened and why is it so important?

Yeah, that's a great question and we are certainly seeing a huge amount of news surrounding FTX. So FTX was at its peak the third largest cryptocurrency exchange by volume. And so exchange that was based in the Bahamas. And it aimed to be a bit more of a professional trading platform that offered a suite of exotic derivative products with high leverage. And although retail traders did trade there, FTX was looking to be the exchange that catered mostly to pro traders. And at its peak in 2021, FTX had over 1 million users. And they were based in the Bahamas because the regulatory regime down there had a more permissive stance on some of these exotic derivative products. But they also had subsidiaries all around the world. They had a subsidiary in the United States called FTX US and several other smaller companies. In total, they had about 160 entities worldwide that constituted the FTX Group.

And so, a little bit because of the looser regulatory environment, they're doing some unusual things. What happened?

Yeah, so there's also another component of the FTX empire that's also really important for the story, and that's a company that they own called Alameda Research. It's a quantitative trading firm that was based in Hong Kong. And so what do quantitative trading firms do, for those that might not be familiar on the call? They essentially place bets on the market based on data. They use tons of information and they employ strategies to exploit market inefficiencies. Strategies can include things like arbitrage or market making, and also trading volatility, which in crypto there's quite a lot of. Now early on, Alameda was exclusively a quant trading shop, but they later changed their strategy to take longer-term directional bets on crypto. And of course, all of this was extremely risky. Now many people at Alameda, including Sam Bankman-Fried, the head of FTX, came from Jane Street Capital, which is a quant trading firm in the traditional finance space. So also you have a bit of a red flag there. You have the exchange and then you have the quant trading firm, all part of the same group. There should be a firewall that separates groups like this because exchanges have information that trading shops like Alameda can use to exploit users of the exchange. But there's actually evidence starting to come out that there wasn't much of a firewall between the two entities. Alameda was heavily trading on FTX and they were using insider information on FTX to take advantage of that market situation. What ended up happening was in the early days, Sam Bankman-Fried made quite a lot of money on arbitrage opportunities by himself. He saw an arbitrage opportunity between the United States and the Japanese market, where Bitcoin was selling for less on the US market, and he could send it to Japan, sell it for more, and as long as you can get that cash back, he can keep rinsing and repeating and making money that way. And allegedly he made about $20 million through that arbitrage trade. He took that initial money and he thought, you know what, I want to take this further and he founded Alameda Research, and subsequently he also founded FTX, the exchange. Early in that time, Chinese Canadian businessman, Changpeng Zhao, more commonly known as CZ, he's the CEO of Binance, which is currently the world's largest crypto exchange. CZ invested in FTX and gave them some of their initial capital. So FTX saw rapid growth through the 2020 and 2021 bull run in crypto. And FTX became the third largest crypto exchange by volume in that time. Now I want to put an asterisk on that because if you actually look at the volume, what is now starting to be evident was that Alameda Research was doing a lot of that trading. So a lot of that volume came from an internal entity. So in reality they were likely never the third largest by an organic volume. But they certainly kept up appearances as one of the largest markets to trade on in the world. Now some bad blood started to happen between SBF, the founder of FTX, or Sam Bankman-Fried— we'll call him SBF from now on—, and CZ, the CEO of Binance. Because Alameda Research, that trading firm, they tried to manipulate the bitcoin futures market on the Binance exchange. They dropped a huge sell order looking to crash the price, trying to trigger off massive liquidations on other traders. But it didn't work. Binance had protections in place to prevent that manipulative behavior. The CEO of Binance recognized that these folks over in the FTX empire, over in Alameda Research, were trying to manipulate the market and they started to butt heads quite a bit. So nonetheless, FTX continued to grow and Alameda was making good money. And it's pretty easy to make money during a huge bull market. Almost every bet wins. But FTX wanted to really expand their operation. And they had a huge hunger for capital as did Alameda. And so FTX was looking to raise an eye-popping amount of capital, and they did that using proprietary tokens. So FTX created a token on their platform called the FTT token. Now, FTT tokens function a lot like a stock, and holding them was a directional bet on the success of FTX as an exchange. And so, if you are a holder of FTT tokens on the FTX platform, you get some benefits, you get discounts on trading fees, but you could also use FTT tokens as collateral in market trading, which itself is a huge red flag. FTX would use one third of all their fee revenue to buy FTT tokens on the market and then take them off the market by burning them, which would, in theory, decrease the circulating supply and increase value in the long term. I say that in theory because in reality, there was a lot of FTT tokens that were created, and the price of FTT tokens were largely manipulated so that FTX would have an asset that on paper had a lot of value, but in reality, was worthless.

Just remarkable. I'm sorry for the listeners. I'm almost speechless. Having been in the investment business for 30 years, just as you're telling this story, you shake your head at all the criss-crossing and the manipulation. It's amazing that, in this day and age, this can happen. But sorry, I interrupt. Carry on Karim. Or KH. I should call you KH so you fit into that world. DR talking to KH today.

Yeah, everyone goes by their initials, it seems. To carry on, FTX created 350 million FTT tokens, but they only released about 25 million of them into the open market. And so, they artificially constrained the supply of what was being traded up there. Now, when they launched the FTT token, they launched it at a price of about 87 cents per token, but they hit an all-time high of about $85 per token in September of 2021. So that's a huge red flag because there really was no scarcity. With only 25 million tokens in circulation and a whopping 325 million that belonged to FTX and Alameda's reserves, the circulating supply was artificially constrained. So the value of the individual tokens would continue to go up. It's kind of like what happens in the diamond industry, where big diamond companies actually hold back on supply, artificially creating scarcity. This is what FTX did with their FTT token. They artificially held back supply, creating the illusion of scarcity. But in reality, there was a ton of this token. Now, if you do the math on paper, at $80 a piece, that means FTX, with their 325 million tokens, had about $26 billion worth of value on their balance sheet. But we know that FTT tokens are illiquid, meaning that there just isn't enough of a market or demand to buy all 325 million tokens at $80 a piece. So if they ever were to put them back in the market, that price would crash much lower. So the paper value of 26 billion is simply just paper value, but in reality, there's no merit to it. And this really wasn't the only token that FTX created of thin air and manipulated. They had other token plays such as Serum, FIDA, Oxygen Protocol, Maps, and Liquid. They created all these vaporware products and masqueraded them as legitimate crypto projects with tokens. And they had a huge total supply that was mostly controlled by FTX, but a constrained circulating supply to increase the paper value of their books. This is actually really important here because Alameda was part of this, and Alameda held a lot of those tokens. And so on paper, both Alameda and FTX had a ton of money on their balance sheet, but in reality, they really just didn't have that much. Now FTX had a spectacular rise and they spent frivolously. They bought the naming rights to the Miami Heat arena for $135 million. They secured celebrity endorsements from people like Tom Brady, Gisele Bündchen, Stephen Curry, Shaquille O'Neill, David Ortiz and Naomi Osaka. They had a Super Bowl ad that featured Larry David, the creator of Seinfeld and star of Curb Your Enthusiasm. And SBF, Sam Bankman-Fried, was on the cover of Fortune magazine. Some people were calling him the next Warren Buffett. And when the crypto markets crashed in early 2022, he came in, swooped in, and tried to bail out all these crypto companies. So many people were comparing him to the JPMorgan of crypto. He was at the height of his game. And also, SBF was very politically connected. He donated heavily to politicians. He spent about $40 million on Democratic candidates in the 2021-2022 election cycle. He was the second largest donor to the Democratic Party. His co-CEO is a major donor to Republicans, spending about $20 to $25 million in the last election cycle as well. So the FTX company as a whole was throwing a ton of money around in political circles, trying to gain influence. SBF had a major presence in Washington. He was always there advocating for regulation that favored centralized crypto exchanges like FTX. And he was very well connected in regulatory and political circles. There are documented meetings between SBF and the SEC chair Gary Gensler. There are photos with the CFTC commissioner Caroline Pham, and several senators were working with him and co-authoring a bill with him in order to promote crypto regulation in the US government. So ultimately, he played the part of the crypto poster boy, hiding behind a veil of legitimacy. But in reality, there was just a massive fraud that was going on behind the scenes. Also in 2021, I should note that CZ of Binance, being one of the initial investors of FTX, he had quite a large equity stake in FTX. And in 2021 he cashed up and Sam Bankman-Fried paid CZ with about two $2.1 billion worth of stablecoins and FTT tokens. So CZ’s holding of FTT tokens played a critical role in how this house of cards ended up crashing down. So then the fall. Now we know that crypto trading is risky. Alameda put up a lot of illiquid tokens as collateral to borrow lots of money on directional trades that just didn't work out. And so when their lenders started calling back their loans, the co-CEOs, Sam Trabucco and Caroline Ellison of Alameda Research, they didn't have the money to pay back their loan so they went to Sam Bankman-Fried for help. And so Sam Bankman-Fried realized that there was a huge hole in the Alameda balance sheet because of these bad loans. So what did Sam do? He lent the money, but he lent them client money. And that's the issue. He stuck his hand in the cookie jar. Now on paper, Sam tried to balance out those client money loans by taking collateral from Alameda. But what did he take collateral in? He took collateral in FTT tokens which we know are worthless. On paper they're worth a lot, but in reality, they're not. So he lent out good money on bad collateral and he was kind of hoping to focus by for a long time. They had to sit and wait and they were hoping that crypto markets would turn around and recover and then they could eventually patch up the holes and go back to normal. But that didn't happen. The crypto market continued to go down because it was not immune to the interest rate hikes that were happening by the Federal Reserve and traditional markets. So crypto continued to go down and down and down. So ultimately, they stuck their hand in the cookie jar and lent out good client assets and they got burned by this. A lot of this went unnoticed for the longest time. But then, on November 2, crypto news website CoinDesk, got a hold of and reported on Alameda Research's balance sheet. And on it there were some surprises. Their largest individual holding was about 366 billion dollars of FTT tokens, which we know are not worth a lot. And that's kind of strange for a shop that's supposed to be segregated from the exchange if they were so invested in that exchange. Their balance sheet also revealed about 2.16 billion dollars of FTT tokens as collateral. So that just showed that they borrowed heavily against FTT tokens. They also had about 3.37 billion dollars of other crypto assets which were mostly illiquid, smaller tokens which they could not realize that value if they tried. And when it came to cash, they only had about 134 million dollars of cash on it. So what did this report from CoinDesk tell the world? Well, it told the world that Alameda Research was heavily in debt using illiquid FTT as collateral. The only lender that would take FTT as collateral was the FTX exchange. So this showed that the ties between the exchange and Alameda were too tight, and the collateral, once again, is largely made up of a manipulated illiquid token that FTX made up out of thin air. So this is where CZ comes into play. Remember, he held a lot of FTT tokens from his cash-out in 2021. And at the time, he held roughly 530 million dollars’ worth of FTT tokens. So this is where he took his kill shot. Seeing that the house of cards that FTX was built on was about to crumble, CZ announced on Twitter that he would be liquidating his 530-million position of FTT tokens. Now, of course, we know if you liquidate 530 million dollars of FTT, that would crash its value. And so FTT was about to get hit really, really hard. So the balance sheet irregularities published in CoinDesk and the impending crash of the FTT tokens that was triggered by CZ’s tweet triggered a bankrupt. All the clients of FTX started getting nervous about their deposits into the FTX platform. So they started to panic and tried to withdraw as much of their cash and their crypto as possible from the FTX platform. But really, the crypto wasn't there. The crypto wasn't there to give back to the clients. The cash wasn't there to give back to the clients. It just simply wasn't enough on the balance sheet of FTX to make their clients hold. And so the FTT token crashed hard, which pretty much was their entire paper value. The assets weren't there. It created a bit of a death spiral that ended up causing the FTX to unplug. Interestingly enough, Sam Bankman-Fried at this time, was tweeting out that things were fine; but they were not fine. He tweeted out that they do not invest client assets, not even in US Treasuries, but this is not true. He tweeted out that FTX is heavily regulated and they have gap audits with $1 billion of excess cash. Once again, none of it was true. And then on November 8, FTX froze withdrawals entirely, and clients were not able to take out their cash. Then on November 9, SBF announced on Twitter that CZ of Binance was interested in acquiring FTX after doing some due diligence. So not only did CZ do a kill shot, but he was looking to just swoop in and take it all. Now during this time, though, there was on-chain evidence on the crypto blockchains that FTX was transferring money to Alameda. That might be evidence of some kind of criminal behavior. They froze accounts from their clients, but they're still moving around money to other people within their enterprise. Then, on November 10, CZ of Binance announced that there was no deal to acquire FTX. He looked at their balance sheet. He saw that the hole was just simply too big to fill. And he said: I'm not going to buy this. And FTX came crashing down even harder. Now, suspiciously, FTX was making even more withdrawals and FTX told the world that they had to honor withdrawals to their Bahamian clients as per the regulator's request. But then the regulator came out and said that they never made such a request and that was a lie. So speculation has it that FTX was allowing select employees and member of their inner circle to cash out while the rest of their clients could not. So yeah, ultimately you can see that there's fraud all over the place here. And then on November 11, FTX announced that they were filing for chapter 11 proceedings in the United States.

Wow. Following this in bits and pieces, I just never heard a complete synopsis and so well explained around what happened. What an incredibly elaborate fraud. Now in the crypto space, and those were the tools and the individuals associated with crypto who are perpetrating this fraud and this scheme, but it has all the classic earmarks of financial fraud; whether we go back to a Bernie Madoff. It just happens to be in the crypto space. So do you think this permanently taints the crypto space in any way or do you think this is a blip and people will see through it that this again is just an elaborate scam that just happens to be in that space? And as we discussed on the last podcast, there's a lot of legitimate reasons for cryptocurrencies blockchain and this space to become a more important part of global finance.

Yeah, that's a great question and really when it comes down to crypto itself, it continues to work. The Bitcoin and Ethereum blockchains continue to produce blocks and process transactions. Decentralized finance platforms on Ethereum continue to issue and manage collateralized loans and facilitate decentralized trading. Centralized finance or C-Fi failed, but decentralized finance or D-Fi continue to chug along. So we have to remember that crypto assets were originally meant to disintermediate the need for trust. Exchanges and centralized players could be replaced by code that lived on blockchains governed by strict boundaries in that code. In other words, finance could operate against a set of code rules with no room for human error or fraud. In practice though, too much of the crypto space became centralized among players that simply couldn't be trusted. They took the assets from clients and promised to manage it and offer financial services on them in a centralized way, much like banks manage money today. But unlike banks, these companies lack regulation and oversight. Greed and power got to several of these people and in the end, once again, they stuck their hand in the cookie jar and they got burned. The ideals of what crypto can be still remain. But this is not a crypto problem as much as it is a centralized company problem. They just happened to be using crypto instead of cash and securities to pull off this fraud. Now, yes, crypto is new and the lack of understanding makes it easier for fraudsters to pull off frauds like this. But hopefully reasonable regulation will come into play that will hold centralized players more accountable and reduce the overall risk in this industry. And we do certainly expect a strong regulatory response to come out of this. And so this story is still unraveling, though. There's a lot of contagion. Being the huge borrower that Alameda was and the huge exchange that FTX was, several firms, whether they’re hedge funds or other trading firms, and you name it, we're all kind of intertwined and exposed to this. And it seems like every day new company is announcing their exposure to this and writing off massive losses or even claiming bankruptcy. So this is going to play out for several more weeks or even several more months before we understand the full scope and impact of this fraud.

Yeah, what I'm struck by, just as you said, is these are people who clearly use arbitrage quite a bit in terms of their trading and the way they play markets. And arbitrage, just for listeners, is when you're trying to identify a mispriced asset. You know the asset is worth ten, the market has it at five, and you go in because of your knowledge and you buy the asset and sell it. Just a very basic explanation of arbitrage. And it seems like the arbitrage here was that they had a better understanding, they were more comfortable in the crypto space and they use that as the front for what is really just a classic, as you say, centralized or classic financial system fraud. And other people being uncomfortable in that space and recognizing there's not as much regulation, they were able to perpetrate this and it becomes a crypto story, but like all of these things, it's really just a fraud story that happens to infect that space. And as you say, we'll continue to see some impacts over the next several months.

Yeah, definitely. And also something I should note, which is actually quite exciting, is Michael Lewis, the author of The Big Short, Flash Boys and Moneyball, he actually spent the last six months hanging around Sam Bankman-Fried, profiling him for his next book. So he's got tons of great information. This will certainly be made into an interesting movie someday and we have that to look forward to. But I do want to touch on quite possibly the craziest turn of events that happened after the bankruptcy filing. Now the crypto wallets that FTX had are on the blockchain, so they're public. You can see them and you can see their balances in real time. And shortly after announcing the bankruptcy, all of a sudden there was some interesting movement of crypto from those wallets to outside wallets. People started to notice that those wallets were getting drained. And so a blockchain analysis firm served the crypto outflow of $663 million. But they say that 477 of that was stolen by a hacker and the rest of it was what FTX tried to secure into cold storage shortly after the hack started. So what did this hacker steal? Well, they stole all sorts of coins and they stole their stable coins, a lot of their tokens, they stole Ethereum, they stole everything they could and they actually ended up with a large amount of Tether stable coins and USD stable coins, which are tokens that live on blockchains like Ethereum or TRON or other blockchains that are pegged to the US dollar. Now, this hacker knew that the creators of Tether and USDC, or US dollar coin, could freeze those assets remotely. So in the essence of time, they wanted to go convert those stable coins into crypto as quickly as possible. So we saw all this suspicious activity where not only did they steal those tokens or move them, but they were trying to exchange them for Ether on decentralized exchanges, for Ethereum and TRON and other crypto assets that couldn't be frozen remotely. And this story is still developing, but it appears that the hacker actually made a mistake. When they were trying to send stable coins on the TRON blockchain to convert to TRON, their transactions failed. And that's because they didn't have enough of the native TRON token to cover transaction fees. They had the stable coins, but they didn't have the TRON token to pay the piece to the network. So after several failed attempts, the hacker realized that they needed TRON tokens in their wallet as well. So they actually transferred TRON tokens from a centralized exchange called Kraken to their wallet. Now, interestingly enough, Kraken does KYC. They know who did that. So the story is still developing, but the Kraken head of security had said that they know the identity of that account holder and they confirmed that this person is a US citizen and that he’s working with law enforcement right now. So the hacker may have inadvertently revealed their identity. So it will be interesting to see how the story plays out.

Wow, Karim, absolutely fascinating. And again, I don't think anyone does it better in terms of telling the story in a way that you can follow along and understand it. So hopefully we're hoping to continue to check in with you on a semi-frequent basis because I know how busy you are. But thanks for the time today to highlight what happened and the impact, because I really think it it'll help people understand that this is— and you correct me if I'm over emphasizing this— but to me, I walk away going, this isn't really a crypto story. It happens in the crypto space, just where a lot of regulators, a lot of investors are just not as familiar, not as comfortable. There are experts who are there and they were taking advantage of the system, but in a very classic way. And so, this really doesn't taint crypto. These are just fraudulent actors and they're getting their comeuppance.

And that's absolutely true. And unfortunately, too much of the crypto space and too much of the value in crypto is tied to the activity by these actors. A lot of this over-leveraged trading helps to inflate the price of crypto, which we saw hit all-time highs not that long ago. So it's truly hard to say what the value of crypto should be based on its core value proposition of decentralized finance. The water is simply too muddy today with all these bad actors that are influencing the ecosystem, all this market manipulation that still happens, that it's hard to necessarily see what the actual value is. There are good players out there, there are centralized exchanges that are like Coinbase, which is a publicly traded company and is regularly audited by external parties and has their balance sheets published online. But then there are the shady ones like FTX, that were not publicly traded, that had a lot of secrets behind closed doors and they were doing everything wrong. And so what we're hoping for, for consumer protections mostly, is that regulators step in and they come up with a great way to regulate this industry that doesn't stifle innovation, but still allows for the consumer protections that this industry so dearly needs.

Yeah. And so you're optimistic on that front?

Yes, optimistic on it. I always say you can't put the genie back in the bottle. So crypto is out there, blockchain is out there, and it is a decentralized network with no central party that can shut it down. So there's really no way to stop it. It's like almost saying to kill the Internet and stop the Internet from ever happening. You just can't do that. And so, somehow regulators have to work in a way that allows for the responsible flourishing of this industry rather than trying to stop it and pushing it underground because all that will do is create more pain, more havoc globally.

Yeah, the long-term effect is going to be positive, but certainly exposes the need for that additional regulation in the near term.

Yeah, absolutely. And it's terrible that so many people lost money in this. It's absolutely awful. And hopefully justice will be served and things will be made right going forward.

Absolutely. Well, KH, thank you for your time again today. And we'll check back maybe in two or three months and see where things have progressed because it just seems like there's going to be some more twists and turns here.

I'm sure there will be. Thank you for having me. Take care.